Bank Capital’s Riskiest Bonds Are Pricing Like the Safest

Executive Summary

Additional Tier 1, or AT1, bank bonds are trading at near-historic tight spreads despite their complex, loss-absorbing structures. With the ICE CoCo Index offering roughly 206 basis points over benchmark rates, well below its 385-basis-point historical median, investors may not be adequately compensated for coupon-cancellation, extension, and regulatory risks. As banks increasingly issue securities with 10-year rather than five-year initial call periods, AT1s are becoming more duration-sensitive and less of a straightforward credit investment.

Yield Demand Drives Spreads Tighter

AT1 bonds, commonly called CoCos, were created after the 2008 financial crisis to provide banks with loss-absorbing capital before taxpayer support would be needed. They sit above common equity but below most other bank debt in the capital structure. Their coupons are generally discretionary, perpetual, and issuers can write down principal or convert the instruments into equity if specified capital triggers are breached.

The fundamental outlook for many global banks remains sound. Common Equity Tier 1 ratios are generally well above regulatory minimums, while earnings and loan-loss reserves have supported confidence in issuers’ ability to service their debt. That strength, combined with demand for yield, has helped drive AT1 valuations higher.

But the ICE CoCo Index’s options-adjusted spread has compressed to roughly 206 basis points over benchmark rates, compared with a historical median of approximately 385 basis points. The narrowing spread leaves little room for deteriorating risk sentiment, volatility, a discretionary coupon cancellation or a reassessment of bank funding costs.

The Credit Suisse Reminder

The asset class carries a powerful reminder of its asymmetric risk. In March 2023, regulators wrote down approximately $17 billion of Credit Suisse AT1 bonds to zero as part of the bank’s emergency takeover by UBS. The loss represented roughly 10% of the global AT1 index at the time and pushed spreads above 1,000 basis points before they later recovered.

Extension Risk Grows

The central concern today is not primarily immediate bank solvency. It is extension risk—the possibility that a bank does not redeem a perpetual AT1 bond on its first call date. Although many AT1s have an initial five-year call date, issuers have no obligation to call them. After that date, coupons typically reset to a prevailing benchmark rate plus the bond’s original credit spread.

When market yields exceed the coupon payable after reset, banks have an economic incentive to leave the securities outstanding rather than refinance. Investors who bought bonds expecting a five-year duration can instead find themselves holding instruments with a much longer effective duration and potentially large price sensitivity to interest rate moves.

This risk has increased as issuers adopt longer initial non-call periods. About one-quarter of AT1 deals issued this year have been structured as non-call 10s, compared with the more typical non-call-five format, according to Bloomberg reporting. The longer structures allow banks to lock in lower funding costs for extended periods, but they also shift more interest-rate and extension risk to investors.

Rising use of these structures has helped expand average index duration to about 3.7 years from 2.3 years in 2023, according to market data cited. That shift matters because AT1s may behave less like short-duration, credit-sensitive instruments and more like long-duration securities when expected call dates become uncertain.

The downside is compounded by negative convexity. If rates rise or credit spreads widen, a low-reset-spread AT1 can extend precisely when investors would prefer their capital returned. Its price can fall sharply as the market moves from valuing the security to its next call date toward valuing it closer to perpetuity.

Still Attractive Income

AT1s can still provide portfolio income, particularly when issued by strongly capitalized banks with high reset spreads and established call histories. At current valuations, however, issuer selection and realistic extension assumptions are increasingly important.

The asset class has not stopped being a bet on bank solvency. But with spreads compressed and duration rising, it has also become a more consequential bet on interest rates.

We want to hear your views.

Are investors treating AT1 bonds as high-yield credit instruments when they should instead view them as hybrid securities with significant equity-like and duration-related risks?

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